Product differentiation costs
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Evaluation of Accounting Policy and Quality
Ernesto Simon
ACC510 Financial Reporting and Disclosure
Excelsior College
SAMPLE ANSWER
Product differentiation costs and balance sheet quality
Product differentiation plays an important role in promoting company performance. However, costs associated with product differentiation are likely to affect the health of a balance sheet to a considerable extent by presenting quality issues.
Product differentiation could be a highly expensive endeavor. In Starbuck’s case, the company incurs expenses related to market research, training, fair trade and sustainable environmental issues, which to a great extent impact on the company’s liquidity. Smith (2015) notes that investors are more likely to be attracted to companies whose balance sheets indicate higher growth potential and ability to meet short-term obligations. Low cash balances on the other hand could be detrimental in that they could indicate a weak balance sheet. On the contrary, maintaining very high cash balances raises a question of whether the company is not utilizing its resources effectively to create business. The amount used in product differentiation thus considerably influences the quality of the balance sheet.
Product differentiation expenses could lead to a high amount of short-term liabilities at Starbucks, in the form of debts owed to suppliers, thus leading to a poor quality balance sheet. When a company has more liabilities in comparison with cash flows necessary for the repayment of debts, the company’s balance sheet could indicate a possibility of bankruptcy in future. Product differentiation thereby presents potential to cause balance sheet quality issues if the expenses associated with it are too high or if the liabilities take a long time to be cleared, such that they appear overwhelming on the balance sheet.
Capitalizing Starbuck’s brand value
Starbuck’s brand value according to Interbrand.com was 4,062 $m in 2012. Capitalizing the brand value would affect the balance sheet by increasing the value of assets in the company. The change on balance sheet can be illustrated as follows.
Total assets after capitalization = 8,219.2 + 4,062 = 12,281.2
| Before capitalization | With brand capitalization | |
| Total assets | 8,219.2 | 12,281.2 |
| Total liabilities | 549.6 | 549.6 |
| Net assets | 7669.6 | 11,731.4 |
Brand capitalization effects
From a credit analyst perspective and with interest in capturing risk and economics of Starbuck’s activities, I would not advocate brand asset capitalization for the company. This is because it has a negative impact on the general health of the financial statements. The calculations below show the impact of capitalizing the brand, which works by increasing the company’s assets.
= 549.6/8,219.2 = 0.066
After capitalization
= 549.6 / (8,219.2 + 4,062)
= 549.6/12,281.2
= 0.044
Based on the above calculation, it is evident that an increase in assets reduces the debt to asset ratio; an indication that the company is in a position to repay its liabilities effectively. However, the brand value does translate into assets that can be liquidated to pay liabilities unless the company is sold off. Therefore, the lower debt to asset ratio would only create an illusion of great ability to pay debt but this may not be an actual strength for the company.
= 1,383.8/8,219.2 = 0.17
After capitalization
= 1,383.8/(8,219.2+4,062)
= 0.11
The return on assets ratio demonstrates how well a company’s assets are utilized in increasing profitability for the company. Upon capitalization of the brand, Starbucks would appear to have made $0.11 out of every dollar invested, which represents 11% return. This was 17% without brand capitalization, meaning that capitalization would reduce the return to a considerable level. Consequently, this may not reflect well on the company’s finances.
Shareholder equity before brand capitalization = 5,109
Shareholder equity with brand capitalization = 12,281 – 3,104.7 = 9170.8
Return on equity ratio before brand capitalization = 1,383.8/5,109 = 0.27
ROE after brand capitalization = 1,383.8 / 9170.8 = 0.15
Return on equity reflects the return on investments. In this scenario, it is demonstrated that stakeholders earned $0.27 for each dollar invested. If Starbucks was to capitalize its brand value, there would be a $0.15 gain for every dollar, which essentially appears lower for the investors. Given that return on equity is an indication of business health, a 15% return on investment would be considered unhealthy for the business compared to 27% recorded before capitalization.
Long-lived assets
Starbucks evaluates impairment of its long-lived assets when it is apparent that carrying values may not be recoverable. Based on this action, the quality of accounting under GAAP and IFRS is assessed as follows. Both GAAP and IFRS require testing of long-lived assets for impairment when there is existence of an impairment indicator, in addition to providing guidance on when to test. This is considerably relevant in improving the quality of accounting for long-lived assets as applied in Starbuck’s case. Secondly, both accounting standards call for impairment tests at least annually for indefinite-lived intangible assets such as goodwill, and more frequently when indicators for impairment exist. This is bound to enhance the quality of accounting by ensuring that the value of long-lived assets is updated.
The accounting policy for Starbucks in establishing useful life where a lease renewal option exists ensures that the company can accurately estimate the useful life of the lease. Starbucks uses the original lease term to calculate the useful life, which ensures that the useful life can be recalculated at the renewal period to provide a better estimate. In the event of building modification and improvements during a lease for example, the useful life may improve considerably. Calculating a useful life that is effective throughout the lease period may not represent the actual useful life of the lease. The approach used by Starbucks is therefore appropriate for the company and can significantly enhance the accuracy of its financial position.
Estimate of average useful life
A company’s accounts must demonstrate any changes in estimates, by prospectively accounting for them in the financial statements. Prospective application ensures that there is no need to undertake frequent revisions on previous period figures that may lead to excessive complications in financial statements through having to revise them to accommodate new changes.
| 2012 | 2011 | 2010 | 2009 | |
| Depreciable cost | 6,592.8 | 5,990.9 | 5,657.1 | 5,523.5 |
| Depreciation expense | 580.6 | 550 | 540.8 | |
| Depreciation rate | 8.8% | 9.2% | 9.5% |
Depreciation rate x depreciable asset cost = annual depreciation
Depreciation rate = annual depreciation/ depreciable asset cost
Depreciation rate 2012 = 580.6/6,592.8 = 0.088 = 8.8%
Depreciation rate 2011 = 550/5,990.9 = 0.092% = 9.2%
Depreciation rate 2010 = 540.8/5,657.1 = 0. 095 = 9.5%
Average depreciation rate = 9.16%
Starbucks uses straight-line depreciation where,
Depreciation rate = 1/no. of years of useful life
No. of years = 1/depreciation rate
=1/9.16% = 10.91
The average useful life of Starbuck’s assets based on the information above is 10.91 years.
Effect on net income and basic earnings per share
Effect on income
Depreciation using 2011 average = 9.2/100 x 6,592.8 = $606.5.
Increase in depreciation expense = 606.5 – 580.6 = $25.9
New net income = 1,383.8 – 25.9 = $1,357.9
Given that expenditure reduces the value of net income, the income statement would show a reduced net income. If the average depreciation for 2011 was used in place of 2012, the net income would decrease by the value of the added depreciation. The new depreciation expense would be $606.5. This depreciation expense is higher than $580.6 obtained using the 2012 rate and this results in a lower net income.
Effect on basic earnings per share
EPS = $1,357.9 – 7.5/754.4
EPS with new income = 1.79
A decrease in the income would lead to a decrease in the earnings per share. Net income is directly proportional to EPS and this means that a higher income is likely to result in a higher EPS. A reduction in the income results in a lower numerator, hence leading to a lower fraction. In this example, the net income decreases, leading to an EPS value of 1.79 compared to the previous value of 1.83 as provided in Starbuck’s 2012 financial statements.
Significance of the inventory reserves
Inventory reserves promote the quality of financial statements by ensuring that the company can shield itself from unforeseen circumstances that lead to lower cost of their inventory lower, spoilage, theft or obsolescence. Starbuck’s policy on inventory reserves not only assures quality for its customers but it also means that the company protects itself from balance sheet and income statement deterioration. This is because in the event of a lower cost for inventory than anticipated, the inventory reserve can cater for the changes. In the event of plummeting prices for example, Starbucks would record the difference by reducing that inventory account and increasing cost of goods by the change. The company’s total assets are reduced and so does the net income. However, the overall loss effect is shielded by the inventory reserve, which ensures that the loss from lower prices does not affect the company’s financial position.
Revenue recognition for store value cards
In accounting perspective, funds from customers in the form of store value cards or gift cards are considered as unearned revenues and a liability. In this respect, they can only be recorded as sales revenue once redeemed, thus eliminating the liability. Store value cards have the potential of affecting balance sheet quality because they increase liabilities. The management’s decision to recognize unclaimed cards is based on assumption that the owners will not redeem the cards. This means that in the event that the customer utilizes the card, the company may need to reverse the transaction, thus affecting the quality of its income statement. Starbucks recognizes the value of stored value cards when they are redeemed or tendered for payment. This ensures that income is only recorded once it has been earned, thus maintaining the quality of financial statements. In certain circumstances, the stored value cards may remain inactive for long periods or not be redeemed within a certain period of time, whereby the company can declare the likelihood for redemption remote and thus recognize the value of the cards as earnings. Income on unredeemed value cards increases the earnings for the company.
Reference
Wahlen, J. M., Baginski, S. P. & Bradshaw, B. (2014). Financial Reporting, Financial
Statement Analysis and Valuation. San Francisco, CA: Cengage Learning, 2014
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